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Stock Market and Economic Update August 21, 2011

August 21, 2011 — Sam H. Fawaz

The past week hasn’t been particularly kind in the stock markets as we saw little follow-through on the previous week’s rally. My upside target of 1230-1260 in the S&P 500 index was not even approached before selling resumed at around 1208.

A few economic reports from last week have me a bit more concerned about the possibility of a recession within the next twelve months. Although the economic leading indicators that I’ve come to rely on from the Economic Cycle Research Institute turned up again this past week, the only components to rise were financial ones, namely the money supply (with the stock market selling being a contributing factor) and the steep yield curve (ultralow interest rates on short duration debt versus higher rates on longer duration debt made possible by the Federal Reserve’s low interest rate policy). Without these two components, the index would have been down 0.5%, which is down three of the last four months. Weekly unemployment claims came in at 408,000 whereas they were starting to trend below 400,000 in the last few weeks.

So the volatility in the market right now is at least partially attributable to concerns about whether a recession is on the horizon or not. If one is not, then the market is undervalued. If one is, then the market is overvalued. So far, the weight of evidence of a recession is still inconclusive, but it appears that institutional buyers are starting to “discount” that possibility as they demonstrate through selling in the markets. The research I read is split about 50/50 about whether a recession is coming, with convincing cases made on both sides. My feeling is that we have a bit further to go on the downside if economic factors or confidence measures don’t start pointing up real soon.

Accordingly, I am becoming increasingly concerned about the behavior of the markets and the economic numbers coming out lately since they haven’t been particularly encouraging. Accordingly, this past week I increased my clients’ hedges and continued to slightly reduce exposure to equities just to be on the safe side.

This week will be critical since the Federal Reserve Chairman (Ben Bernanke) will be speaking on Friday and will reveal any further measures they may take to ease recession concerns and restore confidence to the markets. More information about how the Eurozone will handle its debt crisis should help calm the markets. But based on the market action on Thursday and Friday, it seems that many institutional and retail investors are not waiting to hear what the Chairman has to say or what solution the Eurozone might propose to avoid a deepening debt crisis. They have therefore been selling and may continue doing so into this week.

I will continue to monitor the markets day to day and make further adjustments to portfolios and increase hedges as conditions warrant. Since the market is heavily oversold, we should expect some level of a bounce this week, if only for folks to prepare for any surprise announcement the Federal Reserve Chairman might offer to help propel markets higher.

Bottom line, it’s too early to reach conclusions about whether or not the April high was an important top in the market. If it was, it was unlike any market top of the past 50 years, with both the LEI and market breadth still hitting new highs after the top. When panic selling spreads across the board – good quality companies go down along with the overvalued speculative stocks. I can say that barring some type of financial Armageddon, I believe the downside valuation risk in this market is far less than in 2007-08.

My major equity allocation decision is to give this market more time before making any major adjustments. What is needed –more than anything else– is stability and confidence. Only time and stability can calm the emotional extremes and fears, which still come out of the woodwork on a daily basis. But as I’ve said, if the retest (of the S&P 500 index lows of 1100) is able to hold above the lows of last week, then it could provide a strong market base if evidence of a recession does not increase in coming weeks.

Again, please do not take this message as advice to buy or sell any securities; please consult with your investment advisor (or us!) This message is not intended to forecast what will happen in the market since no one (including me) can do that. My objective is to share what I’ve been hearing, reading and researching, the end result of which is one of cautious optimism.

Please don’t hesitate to contact me if you need any help with your personal financial situation or investments. I welcome your feedback and questions always.